BREAKING DOWN 'Participatory Notes'

Foreign institutional investors (FIIs) provide quick money entering the Indian capital market. Because of the short-term nature of investing, regulators have fewer guidelines for FIIs. To invest in Indian stock markets without the hassle of involvement with the regulatory approval process, FIIs trade P-notes.

What Participatory Notes Are

P-notes are offshore derivative instruments with Indian shares as underlying assets. Brokers and FIIs registered with SEBI issue the instruments and make investments on the FII’s behalf. Brokers must report their P-note issuance status to SEBI each quarter. The notes allow foreign investors with high net worth, as well as hedge funds and other investors, to invest in Indian markets without registering with SEBI. Investors save time, money and scrutiny associated with direct registration.

Pros and Cons of Participatory Notes

P-notes are easily traded overseas through endorsement and delivery. They are popular because investors anonymously take positions in Indian markets, and hedge funds anonymously carry out their operations. Some entities route their investments through P-notes to take advantage of certain countries’ tax laws.

However, because of the anonymity, Indian regulators face difficulty determining a P-note’s original and end owner. Therefore, much unaccounted money enters the country through P-notes. In addition, SEBI has no jurisdiction over trading P-notes. Although FIIs must register with SEBI, the P-notes trading among FIIs are not registered. For this reason, India’s government is concerned that P-notes are being used for money laundering.

For this reason, the Special Investigation Team (SIT) wants stricter compliance measures put in place for trading P-notes. However, when the government proposed putting trading restrictions on P-notes in the past, the Indian market became extremely volatile. For example, around the time the government began talking about curbing P-note trading in October 2007, the market dropped 1744 points. Because FIIs help fuel the growth of the Indian economy, industries and capital market, and because increasing regulations on P-notes would increase the difficulty of foreign money entering the market, the Indian government and investors reacted with fear. The government ended its discussion on regulating P-notes.